Legal Aspects of Real Estate. Chapter 12

Legal Aspects of Real Estate Chapter 12 Slide Text Number 1 It takes a lot more than pocket change to buy real estate. As a result, most real estate purchases involve a loan, and some involve more than one. Buyers, sellers, and real estate agents need to understand the rights and obligations of borrowers and lenders: buyers, since they'll be borrowers; sellers, since they may be lenders; and agents, since they'll have to help the parties obtain financing. 1 This chapter explains promissory notes and security agreements, the basic financing documents. It describes the foreclosure process what happens when a borrower defaults. It also takes a brief look at the land contract, a security device no longer widely used in California. The chapter closes with an overview of some state and federal consumer protection laws that regulate real estate lending. 2 A PROMISSORY NOTE makes a promise to repay a debt. One person loans another money, and the other signs a promissory note, promising to repay the loan (plus interest, in most cases). The borrower who signs the note is called the MAKER, and the lender is called the PAYEE. Today, almost all promissory notes are negotiable instruments. One reason this is true is because of secondary marketing. Unless the promissory note given for a real estate loan is negotiable, it will be very difficult for the lender to sell the loan on the secondary market. The big agencies such as Fannie Mae and Freddie Mac, also known as the Federal National Mortgage Association and Federal Home Loan Mortgage Corporation, won't even consider it. 3 A person borrowing money to buy real estate signs a promissory note in favor of the lender. In addition, the borrower signs a security agreement, such as a deed of trust or mortgage. The SECURITY AGREEMENT is a contract that makes the real property collateral for the loan. It creates a lien on the property. If the borrower doesn't repay as agreed in the promissory note, the security agreement gives the lender the right to foreclose. Basically, in foreclosure the property is sold and the proceeds are used to pay off the loan balance. 3 A promissory note can be enforced whether or not it is accompanied by a security agreement. The payee/lender can file a lawsuit and obtain a judgment if the maker/borrower breaches by failing to repay. Without a security agreement, however, the judgment may turn out to be uncollectible. For example, the borrower may already have resold the property, so there's nothing left for a judgment lien to attach to. 3 By creating a lien on the property at the time of the loan, a security agreement ensures that the lender will be able to get at least some of its money back. Because real estate loans are substantial sums, they are virtually always secured. Security agreements will be discussed in detail in the next section of the chapter. For now, let's look more closely at promissory notes. 3 In a real estate loan transaction, the promissory note should state that it is secured. The note should identify the security agreement by date or recording number. The note and the security agreement are signed on the same date, and are linked together. If the lender negotiates the note, the security interest in the property is automatically transferred along with it. The security agreement can't be assigned unless the right to payment under the note is also transferred.

4 The note generally states the loan amount (the PRINCIPAL), the amount of the payments, and when and how the payments are to be made. It includes the MATURITY DATE, when the loan is to be fully paid. The note also lists the interest rate, which may be either fixed or adjustable. 4 When a noninstitutional lender (a private individual or business, as opposed to a bank, savings bank, or similar regulated lending institution) makes an adjustable-rate loan secured by residential property with four units or less, California law requires the promissory note to include this warning in large, boldface type: NOTICE TO BORROWER: THIS DOCUMENT CONTAINS PROVISIONS FOR AN ADJUSTABLE INTEREST RATE. The law also places a number of restrictions on noninstitutional, residential, adjustable-rate loans; for example, the rate can't change more than once every six months. 4 Promissory notes are classified according to the way the principal and interest are to be paid. With a STRAIGHT NOTE, the periodic payments are interest only, and the full amount of the principal is due in a lump sum when the loan term ends (see Figure 12-1). With an installment note, the periodic payments include part of the principal as well as interest. If the installment note is fully amortized, the amount of the payments is enough to pay off the entire loan, both principal and interest, by the end of the term. If it is only partially amortized, the payments don't cover the full amount of principal and interest, and a balloon payment will be due at the end of the term. 4 A BALLOON PAYMENT LOAN is one that provides for a final payment that is more than twice the amount of the immediately preceding six regularly scheduled payments or contains a call provision. Borrowers often find it more difficult than they anticipated to come up with the extra money at the end of the loan. As a result, California law doesn't allow balloon payments on certain loans secured by residential property. We will talk more about this later in the presentation. When a residential loan with a term longer than one year calls for a balloon payment, the lender is usually required to send the borrower by certified mail a reminder notice at least 90 days (but not more than 150 days) before the balloon payment is due. 4 A promissory note usually contains provisions that explain the consequences of failure to pay as agreed. Real estate lenders often protect themselves with late charges, acceleration clauses, and similar provisions. All of these are recited in the promissory note. We'll discuss these and other optional loan terms later in the chapter, after an overview of security agreements. 5 According to the original theory behind real estate security agreements, the borrower transferred title to the property to the lender (or a neutral third party) during the loan period. When the loan was paid off, title was transferred back to the borrower. The language in some security agreements still reflects this theory, stating that the borrower "conveys" the property; after the loan is paid off, a "reconveyance" is recorded. This is essentially a legal fiction. For all practical purposes, the security agreement merely creates a voluntary lien against the property, and no real transfer of title is involved. The lien enables the lender to foreclose if the borrower defaults. 5 There are two main types of real property security agreements: deeds of trust,also called trust deeds, and mortgages. Either type must be in writing and must meet the formal requirements for a deed. Either creates a lien on everything that would be transferred by a deed, so it includes the fixtures and the appurtenances such as water rights, as well as the land and the improvements. 5 The key difference between the two types is their foreclosure procedures. Mortgages

historically did not have a power of sale clause, requiring foreclosure judicially, that is, by filing a lawsuit. A deed of trust, on the other hand, is usually foreclosed nonjudicially, without going to court. That saves the lender a lot of time, money and effort. 5 In California, nearly all lenders use deeds of trust instead of mortgages. 5 A survey of California title insurers indicated that deeds of trust are used in about 98% of all recorded real estate transactions. For this reason, our discussion will focus on deeds of trust. 6 A trust deed identifies the parties and should include a full legal description of the security property. A lender doesn't want there to be any doubt about what its lien covers in case foreclosure is necessary. 6 The trust deed refers to the underlying debt and the promissory note that it secures. 6 It states the total amount of the debt and the maturity date, but usually doesn't go into more detail. The interest rate and the amount of the payments, late charges, and 6 other charges are generally found only in the note. However, when a noninstitutional loan secured by residential property, having one-to-four units, is subject to an adjustable interest rate, a provision explaining the rate must be included in the trust deed as well as the note. 6 Deeds of trust do go into considerable detail about the borrower's obligations regarding care of the property and the title. The borrower agrees to insure the property against fire and other hazards. (California law prevents the lender from requiring insurance for more than the replacement value of the improvements, however.) The borrower must not commit WASTE (something that substantially decreases the value of the property) or allow the property to deteriorate. The trust deed grants the lender the right to inspect the property, to make sure the borrower is maintaining it. 6 The borrower agrees to keep property taxes, special assessments, and insurance up to date. If the borrower allows any of these bills to become delinquent, the lender has the right (but not the obligation) to pay them. This is important to the lender, since delinquent taxes reduce the value of the security property. If the delinquencies become severe, the taxing authority can foreclose, and the tax liens have higher priority than the trust deed. Any amounts the lender pays to prevent the taxes from becoming delinquent or the insurance from lapsing will be added to the borrower's debt and may cause the lender to declare a default and foreclose. 6 The key provision in a deed of trust, the one that makes it different from a mortgage, is the POWER OF SALE CLAUSE, where the borrower grants the trustee the power to sell the property in case of default. This is what enables the lender to foreclose nonjudicially rather than having to file a judicial foreclosure suit. (Modern mortgages generally do have power of sale clauses, like deeds of trust, but are still infrequently used in California.) 6 A trust deed usually briefly outlines the procedures to be followed if the trustee exercises the power of sale and forecloses. For the most part, however, these procedures are prescribed by law. The foreclosure process is described later in this chapter. 6 A lender always records its trust deed since its lien priority is determined by the recording date. 6 In California, a county recorder cannot accept a trust deed unless the grantor's (borrower's) signature on the document is acknowledged and notarized. The document must also include the grantor's address, along with a request that any notice of default or notice of sale be sent to that address. 7 Title insurance companies often serve as trustees for deeds of trust, and one company

may record hundreds of documents each month. To cut down on recording costs, a title company may record a FICTITIOUS TRUST DEED, which is a standard trust deed form that hasn't been filled out. Once the company's blank form has been recorded, it's only necessary to record the first page and signature page of any actual trust deed that is executed on that form. The standard provisions on the middle pages are incorporated into the actual trust deed by reference to the recording number of the fictitious trust deed. Therefore, if you look up a trust deed in the public record or request a certified copy from the recorder, don't be surprised if the document is incomplete. 7 If the borrower is going to pay off the existing loan, the lender must give the borrower a beneficiary statement if requested by the borrower. The BENEFICIARY STATEMENT shows the borrower the exact amount due on the loan. Once a trust deed borrower has paid off the entire amount of the debt, he or she is entitled to a FULL RECONVEYANCE of the trust deed, a document stating that the debt secured by the deed of trust has been discharged. 7 On receiving the final payment, the lender/beneficiary must send the trustee the original promissory note and trust deed, along with a request for reconveyance. The trustee is then required to execute and record the reconveyance document within 21 days. This makes it a matter of public record that the debt has been paid off and the trust deed is no longer a lien on the property. The borrower may ask the trustee for the original note and trust deed. (The trustee and beneficiary are allowed to charge the borrower a reasonable fee for these reconveyance services.) 7 The Civil Code outlines steps the borrower can take to clear title, such as the substitution of the trustee, if the beneficiary and trustee don't execute a reconveyance within the timelines provided by law. A willful (intentional) failure to reconvey is a misdemeanor with a fine of not less than $50, nor more than $400, or imprisonment in the county jail for a period not to exceed six months, or both. Additionally, the trustor is entitled to recover all damages caused by the failure to reconvey plus a mandatory statutory penalty of $500. Damages may include those for emotional distress and attorneys' fees. 7 When several parcels of property are the security under a single trust deed, the borrower may be given a partial reconveyance after a certain portion of the debt has been repaid. The PARTIAL RECONVEYANCE removes the trust deed lien from specified parcels; the lien still attaches to the other parcels. 7 A promissory note is a borrower's promise to repay a loan, and a security agreement gives the lender the power to have the borrower's property sold in case of default. 7 These are the basic terms for every real estate loan. Most real estate loan agreements also include additional provisions governing prepayment, default, and transfer or encumbrance of the security property. Some of these provisions appear in the note, some in the trust deed, and some in both. These common additional terms generally provide extra protection for the lender. This is not surprising; when the parties work out the details of their agreement, the lender is ordinarily in a better bargaining position than the borrower. If you apply for a loan at a bank and start haggling about the prepayment clause, the loan officer may wish you good afternoon and turn her attention to the next customer. However, as you'll see, California law places some limits on the protective provisions a lender can impose, especially on a loan secured by residential property. 8 When a contract states a specific time for performance, the law requires it to be performed at the stated time, not after that time, and also not before that time. Suppose our loan agreement obligates me to pay you $789 on the 15th of each month. I don't necessarily have the right to pay more or pay sooner.

8 Most Conventional Real Estate Loan Agreements Provide For: 8 Late charges, 8 Some also provide for prepayment 8 Acceleration on transfer (due-on-sale), and 8 Acceleration on default,. 8 However, a loan agreement may expressly give the borrower the right to PREPAY, that is, make a larger payment than required, or pay off the entire loan before its maturity date. 9 In fact, prepayment is permitted by the terms of most promissory notes. The note may simply state that the monthly payment is $789 "or more," or that the payments are due "on or before" the fifth of each month. The note may include a provision expressly stating that the borrower has the right to prepay. There may be a PREPAYMENT PENALTY, which is an added expense to the borrower, if the loan is paid before the due date. 9 When a loan agreement doesn't give the borrower the option to prepay, the loan is said to be LOCKED IN. It is extremely unusual for a real estate loan to be completely locked in, but some loan agreements include a lock-in clause that prevents prepayment during a certain period. 9 Case Example: To develop an office building complex in West Los Angeles, the Trident Center partnership borrowed $56,500,000 from the Connecticut General Life Insurance Company in 1983. The interest rate was 12.25%, and the loan was to be paid off in 15 years. The promissory note stated that the partnership "shall not have the right to prepay the principal amount hereof in whole or in part" during the first 12 years of the loan. 9 Everything went smoothly for a few years, but interest rates were dropping during that period. By 1987, the 12.25% rate on the Trident Center loan was good for the lender, but bad for the borrower. The partnership wanted to refinance to take advantage of the lower rates that were available. However, refinancing would involve paying off the original loan long before its due date. Connecticut General refused to accept the prepayment, and the partnership sued. The court held that Connecticut General's lock-in clause was enforceable; the partnership could not prepay without the lender's consent during the first 12 years of the loan period. Trident Center v. Connecticut General Life Ins.. 9 The California legislature enacted a statute that prohibits lock-in clauses for loans on residential property with one-to-four units. With these loans, the borrower has the right to make a partial prepayment or to pay off the entire loan balance at any time. The lender is allowed to impose a prepayment charge only if agreed to in writing. 9 Even prepayment charges are limited if the property is owner-occupied. For owneroccupied property, during the first five years of the loan, the borrower must be allowed to prepay up to 20% of the original loan amount in any 12-month period without penalty. But if the borrower prepays more than 20%, the lender can assess a prepayment charge. The charge cannot be more than the equivalent of six months' interest on the amount of prepayment over 20%. 9 During the first five years of a loan for owner-occupied property, the borrower must be allowed to prepay up to 20% oft the loan amount in any 12-month period without penalty. 9 The maximum prepayment penalty on a high priced mortgage loan shall not exceed 2% during the first 12 months of the loan or 1% during the second 12 months. If a mortgage broker arranges only higher-priced mortgage loans, it must be disclosed orally and in writing at the time services are engaged. 9 Example: Suppose a bank has loaned you $100,000 at 10% interest so that you can buy a

condominium unit. If you prepay $20,000 (20%) in one year, the lender can't require you to pay a prepayment charge. 9 However, if you prepay more than that in one year, for example, $25,000 (25%), the lender may add on a prepayment charge. The charge cannot exceed the equivalent of six months' interest on 5% of the original loan amount (25% - 20% = 5%). One year's interest on $5,000 at a 10% annual rate would be $500, so six months' interest would be $250. The prepayment charge could not be more than $250. 9 After a loan on owner-occupied property has been in place for five years, the borrower can't be required to pay any further prepayment charges. A different rule applies to loans secured by single-family, owner-occupied homes that are covered by the Mortgage Loan Broker Law, which is discussed at the end of this chapter. 9 The statute that establishes the residential borrower's right to prepay makes an exception for seller financing. Under this exception, a home seller who carries back a deed of trust for the purchase price can prevent any prepayment during the year of the sale. 9 This addresses a seller's concern about income tax liability. When a buyer prepays all or part of a carryback loan in a large lump, the seller may end up in a higher rate tax bracket, owing much higher taxes on that money than if the payments had been spread out over a few years. 9 Note, however, that this exception doesn't apply to a seller who carries back four or more residential deeds of trust in one year. In that situation, the seller is required to allow prepayment during that year, just like an institutional lender. 9 These rules on lock-in clauses and prepayment charges apply only to loans on residential property where the owner lives in one of the one-to-four units. There are no statutory restrictions on lock-in clauses and prepayment charges for other real estate loans. 9 No prepayment charge is allowed if the residence cannot be occupied, for example, if damage occurs from a natural disaster for which a state of emergency is declared by the governor. 10 Many promissory notes provide for a late payment penalty. The penalty may take the form of a flat fee; for example, $5 per month is added to the debt until the overdue payment is received. Or there may be a default interest rate. For example, the interest rate on the loan balance is ordinarily 8%, but 10% is charged on any delinquent amounts. 10 Late payment charge provisions such as these generally must comply with the rules for liquidated damages. This means the amount of the late charge must have been reasonable at the time the loan agreement was made. Thus, if a promissory note provided that a $200 late fee would be added to the $500 monthly payment whenever the payment was overdue, a court would undoubtedly refuse to enforce that provision. 10 The borrower must be given notice that a late fee or default rate will be charged. The notice must state the amount of the fee and the date it will be charged, and explain how the penalty is calculated. 10 A default interest rate can be assessed on the delinquent amount until it is paid, but not on the entire loan balance. 10 Example: The interest rate on my loan is 8.5%, but the note provides for a default rate of 10%. My payments are $500 a month, and the loan balance is currently $59,432. For one reason or another, I miss my October payment. The lender can charge 10% interest on the delinquent $500 until I pay it. However, the lender can't charge 10% on $59,432; the interest rate on the nondeliquent balance must remain at 8.5%. 10 The California Civil Code has placed special restrictions on late charges for loans on single-

family, owner-occupied residences. A late charge can't be imposed until a payment is more than ten days overdue. There is a ten-day advance notice requirement before assessing the first late charge. The late charge on a single delinquent payment cannot exceed $5 or 6% of the payment amount, whichever is greater. Only one charge can be assessed against each delinquent payment. Whatever the borrower does pay must be applied first to the most recent payment due. 10 An acceleration clause allows the lender to demand payment of the outstanding loan balance for various reasons, including if the buyer defaults on a loan payment. 10 Virtually every real estate loan agreement provides for acceleration of the loan in case of default. If the borrower defaults, the lender has the right to declare the entire balance due, no matter how many years away the original maturity date might be. This is sometimes referred to as "calling the note"; the provision in the loan agreement is an ACCELERATION CLAUSE or call provision. 10 A lender does not have the right to accelerate unless expressly included in the loan agreement. An acceleration clause in the promissory note allows the lender to accelerate if the borrower fails to make payments on time. An acceleration clause in the trust deed gives the lender the right to accelerate if the borrower breaches any part of the security agreement, for example, by failing to pay the property taxes or keep the property insured. 10 Acceleration is a lender's option, not an automatic event. The lender decides whether or not to accelerate and when, after the borrower has missed two payments, or five or six. But the right to accelerate ends as soon as the borrower cures the default by tendering payment of the delinquent amounts, renewing the insurance, or taking whatever other action is necessary. The borrower can cure the default even after the lender has accelerated the loan. If the default isn't cured, the lender will foreclose. 10 When a lender accelerates a loan because of default and has the property sold, the proceeds from the foreclosure sale are used to pay off the debt. This usually occurs long before the loan's original maturity date, so, in effect, acceleration and foreclosure lead to prepayment of the loan. A lender may not impose a prepayment penalty on a loan secured by residential property with up to 4 units if the lender accelerates the loan pursuant to a due-on-sale (alienation) clause. 10 Case Example: Mr. and Mrs. T borrowed $405,500 from Columbia Savings to buy a home in 10 Rolling Hills. Paragraph 1 of the promissory note provided for acceleration in case of default 10 The note also stated that a fee would be charged for any prepayment, "whether or not such 10 prepayment is voluntary or involuntary,even if it results from Columbia's exercise of its rights 10 under Paragraph 1. 10 Two years later, Mr. and Mrs. T defaulted, the loan was accelerated, and the home was sold at a foreclosure sale. Columbia included a prepayment charge of $22,795 in the price. 10 The foreclosure sale purchaser, Golden Forest Properties, sued for a declaration that it 10 was not required to pay the prepayment charge. The court disagreed, however. The lender and 10 borrowers clearly intended that the prepayment charge would be owed if the lender foreclosed, 10 and this provision of their agreement was enforceable. Qolden Forest Properties v.

Columbia 10 Savings & Loan Assn.. 10 As the Golden Forest case suggests, the terms of the loan agreement are controlling. If the note hadn't specifically stated that the charge would be due even for involuntary prepayment, Columbia Savings could not have collected it. 10 When real property is sold, or otherwise transferred, the new owner takes title SUBJECT TO any existing liens, meaning the lienholders still have the power to foreclose on the property in spite of the transfer. If the new owner fails to pay, the original debtor is still liable for payment. However, the new owner does not necessarily take on personal responsibility for the liens. 10 Personal responsibility becomes important if the lienholder forecloses and the foreclosure sale proceeds aren't enough to pay off the full amount of the lien. In some cases, the lienholder can sue for the remainder. That's called a DEFICIENCY JUDGMENT, it makes up for the deficiency in the sale proceeds. When a new owner takes property subject to existing liens, he or she may lose the property to foreclosure, but isn't personally liable for a deficiency judgment. The lienholder has to collect the deficiency judgment from the former owner. 10 It's different if the new owner assumes an existing lien instead of merely taking title subject to it. In an ASSUMPTION, the new owner agrees to take on personal responsibility for the lien. Then if the lender obtains a deficiency judgment, the new owner will be liable. However, the original borrower (the former owner) remains secondarily liable for a deficiency judgment. If the new owner doesn't pay, the lender can collect from the former owner. The former owner can then go after the new owner for payment, but may be out of luck. Deficiency judgments and anti-deficiency judgment rules are discussed later in the chapter. 10 Even though the original borrower is still liable, an assumption may increase the lender's risk. The lender wants to be paid as agreed, foreclosure is a last resort. The new owner could be a much worse credit risk than the former owner, or might be more likely to allow the security property to deteriorate. 11 Because of these concerns, most conventional real property loan agreements contain a due-on-sale clause. 11 A lender can't include a provision in the loan agreement that prevents the borrower from selling or transferring the security property. In the eyes of the law, that would be an unreasonable restraint on alienation. Transfer of property from one person to another is generally good for commerce, so the law protects an owner's right to freely transfer property. 11 However, lenders can use due-on-sale clauses to protect their interests. A DUE-ON-SALE CLAUSE provides that if the borrower sells or transfers any interest in the property without the lender's consent, the lender has the right to accelerate the loan and demand immediate payment in full. 11 These provisions are also called alienation clauses. ALIENATION CLAUSES are always acceleration clauses, but don't confuse them with the provisions for acceleration on default that were discussed earlier. Here there's no default; the monthly payments, taxes, and so forth have been paid reliably. The borrower has simply exercised his or her right to sell or transfer the property. If a lender chooses to use the due-on-sale clause to accelerate the loan, the full balance must be paid. If it isn't, the lender can foreclose. 11 A due-on-sale clause (also called an alienation clause) is a type of acceleration clause that

demands payment of the entire balance of the loan upon sale or transfer of title. 11 Sometimes (if the new owner is a good credit risk) instead of exercising its due-on-sale rights, the lender is willing to agree to an assumption of the loan. In that case, the new owner is usually required to pay an assumption fee, or a higher interest rate on the assumed loan, or both. The lender and the new owner sign a written assumption agreement, and the former owner has no further liability for the debt. 11 The California Legislature has adopted some rules for due-on-sale clauses in loans on residential property with one-to-four units. 11 For loans made since July 1, 1972, if the loan agreement includes a due-on-sale provision, it must appear in full in both the promissory note and the trust deed. 11 For loans made since January 1,1976, a due-on-sale clause can't be triggered by certain types of transfers. The lender can't accelerate the loan when: 11 1. the borrower's spouse becomes a co-owner of the security property. 11 2. the borrowers are a married couple, and one of them dies, making the other sole owner of the property. 11 3. married borrowers separate or divorce and one of them becomes the sole owner. 11 4. the borrower transfers the property to a trust in which he or she is a beneficiary. 11 In general, if a loan agreement contains both a prepayment provision and a due-on-sale clause, the lender cannot collect prepayment charges after accelerating the loan because the property has been sold. 11 However, federal law prohibits prepayment charges on a loan secured by an owneroccupied home, and state law prohibits prepayment charges on a loan on residential property with one-to-four units if the due-on-sale clause is exercised. 11 Some due-on-sale clauses allow the lender to accelerate the loan not only if ownership is transferred, but even if the borrower encumbers the property with another lien. The borrower can't take out an additional loan using the property as security, even though the first lender's trust deed would have higher priority than the second trust deed. These dueon-encumbrance provisions are generally enforceable. However, federal law prohibits them in loans secured by owner-occupied homes, and California law prohibits them in loans on residential property with one-to-four units. 12 Lien priority is extremely important to every lender. The higher the lender's priority, the more likely that lender is to recover all (or most) of the debt if any lienholder forecloses. 12 As you know, the priority of a trust deed depends on the date it was recorded. A trust deed has lower priority than any voluntary liens on the same property that were recorded earlier, and higher priority than any that were recorded later. 12 A lender can agree to accept a lower priority position than the one established by the recording date. The lender may subordinate its trust deed to another trust deed that was (or will be) recorded later. The earlier trust deed that takes on a lower priority is called a SUBORDINATED TRUST DEED. The later trust deed that is given a higher priority is called the SUBORDINATING TRUST DEED. 12 Subordination is most common when a seller carries back a trust deed for part of the purchase price. The borrower/buyer intends to improve the security property, but to do so, he or she will have to obtain a construction loan. Construction lenders generally insist on having FIRST LIEN POSITION (the highest priority). As a result, the buyer won't be able to get the construction loan unless the seller is willing to subordinate the purchase loan. 12 A subordination clause can be included in the earlier trust deed, or a separate subordination agreement may be drawn up. The provision may subordinate the trust

deed to a loan that has already been arranged, or to one that the borrower intends to apply for. 12 Because subordination can have a drastic effect on the strength of a lender's security, any subordination provision must be drafted or carefully reviewed by a competent lawyer. When the other loan hasn't been arranged yet, the provision should establish strict standards for the quality and purpose of the other loan. Otherwise, the borrower can subordinate the earlier trust deed to any kind of loan and do anything he or she wants with the money. This can make the subordinated lender's security worthless. 12 Case Example: Mr. Handy contracted to buy the 320-acre Gordon Ranch for $1,200,000. The contract provided that Handy would sign a ten-year deed of trust in favor of the Gordons to cover the purchase price. Handy intended to obtain other loans for construction and permanent : financing, and the Gordons agreed to subordinate their trust deed to these other loans. 12 A few months later, however, the Gordons had changed their minds about selling the ' property to Handy. Handy sued for specific performance of the contract. 12 The court stated that a subordination clause "must contain terms that will define and 12 minimize the risk that the subordinating liens will impair or destroy the seller's security." Nothing in the Gordons' subordination provision ensured that Handy would use all of the proceeds from the other loans to improve the security property. As a result, the amount of those loans might be much greater than the amount Handy's : improvements added to the value of the property. If he defaulted and the subordinating lenders I foreclosed, their claims would probably absorb all the foreclosure sale proceeds. Thus, the \ contract leaves defendants with nothing but plantiff's good faith and business judgment to insure them that they will ever receive anything for conveying their land. The court ruled that :; this was not just and reasonable for the Gordons, and refused to make them go through with the contract. Handy v. Gordon, 12 In California, to lessen the chances that an unsophisticated lender will subordinate a trust deed without realizing it, certain trust deeds with subordination provisions must have the words SUBORDINATED TRUST DEED printed in large, bold type at the top of the document. The document also has to include certain warnings about the risks involved in subordination. However, these rules don't apply when either the subordinated loan or the subordinating loan (the later loan) will be for more than $25,000. 13 The purpose of every real estate security agreement is to give the lender the right to foreclose: to have the property sold and the debt paid out of the sale proceeds. The power of sale clause in a deed of trust enables the lender to foreclose nonjudicially without filing a lawsuit. The foreclosure must take place within 10 years of maturity date of the note, or 60 years after recording the deed of trust. 13 The power of sale clause permits nonjudicial foreclosure in accordance with specific terms. 13 A power of sale clause can also be included in a mortgage, making the mortgage just like a trust deed. A standard mortgage does not contain a power of sale clause, and can only be foreclosed through judicial process. 13 For a trust deed lender, on the other hand, judicial foreclosure is an option. There is rarely any advantage to it; nonjudicial foreclosure is always faster and cheaper. (Nonjudicial foreclosure can be accomplished in less than four months and usually costs less than $500; judicial foreclosure can take years and cost thousands of dollars.) Since most foreclosures in California are nonjudicial, we'll look at the nonjudicial procedure in detail.

Later in the chapter, we'll compare the judicial foreclosure process. 13 There are three main steps in the nonjudicial foreclosure process: 13 1. Notice of default 13 2. Notice of sale 13 3. Trustee's sale 13 When a trust deed beneficiary (the lender) asks the trustee to start the foreclosure process, the first step is to record a NOTICE OF DEFAULT, which identifies the trust deed, states that the borrower has breached the terms of the trust deed, and describes the nature of the breach. A Notice of Default cannot be recorded until 30 days after the lender contacts the borrower. Remember, default doesn't have to be failure to make monthly payments on time. Failing to maintain the property, pay the taxes, or keep the property insured can also constitute default. 13 The notice of default is recorded in the county where the property is located. Within ten business days after it is recorded, the trustee must mail a copy to the borrower by certified or registered mail. In addition, a second copy must be sent to the borrower by first class mail, and the sender has to execute an affidavit of mailing. 13 In that same ten business-day period, the trustee must also send a copy of the notice of default, by certified or registered mail, to everyone who requested notice. Anyone who wants to receive notice of default on a particular trust deed can record a REQUEST FOR NOTICE OF DEFAULT. (Sometimes a request for notice of default is included in the trust deed itself.) The request must include an address so that the trustee knows where to send the notice. A commercial tenant wants to know if the landlord is in default. 13 In addition, the trustee has to send a copy of the notice of default to: 13 1. the borrower's successors in interest (that's everyone who has acquired an ownership interest in the property, heirs, for example), 13 2. the junior trust deed beneficiaries (the lenders with lower lien priority than the foreclosing lender), 13 3. the vendee in a land contract with lower priority than the trust deed, and 13 4. the lessee in a lease with lower priority than the trust deed. 13 Like the others, these copies must be sent by certified or registered mail, but they don't have to be sent within ten business days. The trustee has one month after the notice of default is recorded to send copies to these parties. (If any of them want to be notified sooner, they have to record a request for notice.) 13 The trustee's next step is to issue a notice of sale. This can't be done until at least three months after the notice of default was recorded, but it must be done at least 20 days before the date set for the trustee's sale. 13 The NOTICE OF SALE states the time and place that the trustee's sale will be held. It gives the name, address, and phone number of the trustee conducting the sale; it identifies the borrower and the property to be sold. The notice states the amount of the unpaid loan balance and an estimate of the costs and expenses, including a warning to the borrower: 13 "UNLESS YOU TAKE ACTION TO PROTECT YOUR PROPERTY, IT MAY BE SOLD AT A PUBLIC SALE. IF YOU NEED AN EXPLANATION OF THE NATURE OF THE PROCEEDING AGAINST YOU, YOU SHOULD CONTACT A LAWYER." 13 To issue a notice of sale, the trustee must do all of the following at least 20 days before the sale date: 13 1. Post a copy of the notice in a public place (such as the courthouse) in the city or judicial district where the property is located.

13 2. Begin publishing the notice once a week in a newspaper of general circulation in the city or judicial district where the property is located. 13 3. Post a copy in a conspicuous place on the property to be sold. 13 4. Send borrower one copy by registered or certified mail, and one by first class mail. 13 5. Send a copy to each of the other parties that were sent a notice of default. 13 For loans secured by residential real property where the billing address for the loan is different than the property address, the trustee is required to post and mail a notice, when the Notice of Sale is given, addressed to the "Resident of property subject to foreclosure sale" that foreclosure may result in termination of a lease and eviction. The notice must be given in six different languages: English, Spanish, Chinese, Tagalog, Vietnamese, and Korean. 13 In addition, at least 14 days before the sale, the trustee must record a copy of the notice of sale in the county where the property is located. 13 Once the foreclosure process has begun, there are three ways the borrower can prevent a trustee's sale: 13 1. Cure the default to reinstate the loan. 13 2. Redeem the property. 13 3. Give the lender a deed in lieu of foreclosure. 13 When the borrower has defaulted by failing to make payments, or failing to pay taxes, assessments, or insurance, the default can be cured. (Note that a cure isn't always permitted: not if the borrower has committed waste, or if the loan has been accelerated pursuant to a due-on-sale clause, for example.) 13 A default can be cured by paying the delinquent taxes or assessments, reinsuring the property, or paying the overdue amounts (including late charges). In addition, the costs incurred because of the default must be paid (the cost of recording and mailing notices, for example). The trustee's fees and any attorney's fees must also be paid, and these are limited by statute. 13 Before the notice of sale is mailed. Until the notice of sale is deposited in the mail, if the borrower wishes to reinstate, the trustee's or attorney's fees that may be recovered may not exceed $300 for an unpaid principal of $150,000 or less, or $250 if the unpaid principal exceeds $150,000, plus 1/2 of 1 percent of the amount from $50,001 to $150,000, plus 1/4 of 1 percent of the unpaid amount from $150,001 through $500,000 plus 1/8 of 1 percent of any portion of the unpaid principal sum exceeding $500,000. 13 After the notice of sale is mailed. If the borrower wishes to redeem after the notice of sale has been deposited in the mail, the trustee's or attorney's fees are set at an amount that does not exceed $425 on the first $150,000 or unpaid principal, or $360 if the unpaid principal exceeds $150,000, plus 1 percent of the unpaid principal exceeding $50,000 through $150,000 plus 1/2 of 1 percent from $150,000 through $500,000,1/4 of 1 percent of the unpaid principal sum exceeding $500,000. 13 Trustee's or attorney's fees. Any charge for trustee's or attorney's fees are presumed to be lawful when they do not exceed these authorized amounts. 13 It's not just the borrower and the borrower's successors in interest who can cure the default. A junior lienholder might pay off the delinquencies, costs, and fees in order to protect its lien. 13 The default can be cured any time after the notice of default has been recorded, until five business days before the date of the trustee's sale. This is known as the REINSTATEMENT PERIOD. If the sale is postponed, the right to cure the default revives until five business

days before the new sale date. 13 When the default is curable, the notice of default must contain an explanation of the right to reinstate the loan. It must also inform the borrower that the lender may be willing to allow additional time or arrange a payment schedule. The amount necessary for curing the default as of the notice date must be listed, along with a phone number to call for an update of the necessary amount. 13 Once a default has been cured, the loan is reinstated. 13 Regular payment resumes, the lender can't demand higher payments or a higher interest rate because of the earlier default. The borrower may ask the lender to record a notice of rescission. The NOTICE OF RESCISSION gives public notice that the notice of default and notice of sale have been rescinded. The lender must record a notice of rescission within 30 days after receiving a written request from the borrower. 13 Five days before the sale date, the borrower (and all interested parties, such as a junior lienholder) loses the right to cure the default. In that five-day period, there's still a chance to prevent the sale and retain control of the property, but now it becomes necessary to pay the lender the entire loan balance, not merely the delinquencies, plus costs and fees. If the borrower can come up with that much, he or she will own the property free and clear of the lender's interest. This doesn't happen often. Once the trustee's sale is over, the right to redeem the property is lost. 13 The only other way for the borrower to prevent a trustee's sale is by giving the lender a DEED IN LIEU OF FORECLOSURE, where the borrower simply deeds the property to the lender, surrendering ownership. Why would a borrower do that? Often the borrower is going to lose the property anyway, since he or she can't afford to cure the default, much less pay off the entire loan. By giving the lender a deed in lieu, the borrower can avoid liability for costs and fees, and may be able to protect his or her credit rating. 13 A lender isn't required to accept a deed in lieu of foreclosure. The lender can decide whether accepting it will be more advantageous than foreclosing. That may not be the case, for example, if the property is encumbered with other liens. (As explained later in this chapter, foreclosure eliminates all liens junior to foreclosing trust deed.) 13 A trustee's sale is a public auction; the foreclosure property is sold to the highest bidder. 13 The sale must be held during ordinary business hours, in the county where the property is located. The trustee's role is to conduct the sale in a fair and open manner, to protect all interested parties (the borrower, the foreclosing lender, and the other lienholders) and obtain a reasonable price for the property. Upon the sale of the property, the trustee may deduct from the proceeds of the sale those reasonable costs and expenses which are actually incurred in enforcing the terms of the obligation or which are authorized by law to be in an amount which does not exceed $425 or 1% of the unpaid principal sum secured, whichever is greater. The unpaid sum secured is determined as of the date the notice of 13 default was recorded. If the charge does not exceed this dollar amount provided, it is conclusively presumed to be valid. 13 The trustee can postpone the sale, if necessary, to protect the interests of the beneficiary or borrower. Remember that when a trustee's sale is postponed, the right to cure the default is revived until five business days before the new sale date. 13 The foreclosing lender is allowed to credit bid at the sale. With CREDIT BIDDING, the amount owed to the lender is offset against the amount of the bid. No other lienholders are allowed to credit bid.

13 Example: The amount due to the foreclosing lender is $100,000. (This includes the unpaid balance on the trust deed, plus costs and fees.) The lender bids $100,000, which is the highest bid. The lender gets the property without actually paying anything for it. If the lender bid had been $120,000, the lender would only pay $20,000. 13 Suppose there's a junior trust deed on the property with a $15,000 unpaid balance. If the lender on that junior trust deed bid $100,000, he or she would have to pay the full S100,000,not $85,000. 13 After the property has been sold at the trustee's sale, the proceeds are applied in the following order: 13 1. First, the costs of the foreclosure are paid (including costs of publishing, recording, and mailing notices, a title search, and trustee's and attorney's fees). 13 2. Next, the note underlying the trust deed that was foreclosed is paid. 13 3. Then, any junior liens are paid off in order of priority. 13 4. Finally, anything left over is paid to the borrower. 13 If there's nothing left after the foreclosed trust deed is paid off, the junior lienholders get nothing. If there is something left, junior lienholders are sent a notice to file a written claim, and the trustee determines priority. If there's only enough left to pay the first junior lienholder, the second and third get nothing (and so on). If the trustee cannot determine priority, the matter is transferred for determination to the superior court. The foreclosure extinguishes the junior liens: the junior lienholders have lost their security interest in the property, they can't foreclose later on. Not only that, because of the antideficiency rules (discussed below), the junior lienholders have no other recourse, they can't sue the borrower for payment. 13 However, the foreclosure does not extinguish any liens that had higher priority than the foreclosed trust deed (a property tax lien, for example). The purchaser at the trustee's sale takes the property subject to those senior liens. 13 The purchaser at a trustee's sale receives title to the property immediately. The borrower has no further right to redeem the property. If the borrower is still in possession of the property, he or she can be evicted. 13 The purchaser at a trustee's sale is given a TRUSTEE'S DEED (not the same thing as a trust deed!). Like a quitclaim deed, it conveys whatever ownership rights the borrower had, but carries no warranties of title. 13 The beneficiary of a junior trust deed (or any other junior lienholder) has the same right to foreclose as the beneficiary of the senior trust deed. However, as you've seen, if the senior lender forecloses first, the junior lender's security interest will be wiped out altogether. The junior lender may receive full payment, partial payment, or nothing at all. 13 The only protection for a junior lender (besides choosing the borrower carefully) is to submit a request for notice of delinquency to the senior lender(s). 13 If a junior lender knows that the borrower is having trouble with a senior loan, the junior lender can cure the default and reinstate the senior loan. 13 The amount it costs to cure the default is added to what the borrower already owes the junior lender. With the senior loan reinstated, the junior lender can decide whether to foreclose on its own lien. 13 A junior lender can only use a request for notice of delinquency if the security property is residential property with one-to-four units, or if the junior lien is for $300,000 or less. And the junior lender must first obtain written permission from the borrower. Delinquencies of four months or more are reported. The notice fee is $40 and is good for five years; it

can be renewed. 13 Any junior lender can, and should, record a request for notice of default. The borrower's consent is not necessary. The request for notice of default was described earlier in this chapter. When a junior lender has filed a request for notice of default, the trustee has to send a notice of default to the junior lender within ten business days, rather than a month, after recording it. The notice of default doesn't warn the junior lender as early as a notice of delinquency, but it's better than nothing. 14 There are only two parties to a mortgage. The borrower is the MORTGAGOR, the lender is the MORTGAGEE, and there's no trustee. Up until the point of foreclosure, the mortgagor and mortgagee have the same rights and obligations as a trust deed trustor and beneficiary. A promissory note secured by a mortgage is the same as one secured by a trust deed, usually containing an acceleration clause and providing for late charges. Like a trust deed, a mortgage requires the borrower to maintain the property and keep it insured, and there's usually a due-on-sale clause. 14 Unlike a trust deed, a mortgage doesn't ordinarily have a power of sale clause. As a result, nonjudicial foreclosure is not permitted. 14 To foreclose, the mortgagee has to file a complaint in the superior court of the county where the property is located within four years of payment being due. The defendants in a foreclosure lawsuit are the borrower and junior lienholders. If the mortgagee doesn't include one of the junior lienholders as a defendant, that junior lien isn't affected by the foreclosure. As with nonjudicial foreclosure, however, all the other junior liens are extinguished. 14 After filing a foreclosure suit, the mortgagee records a notice called a lis pendens. The LIS PENDENS states that a legal action is pending that may affect title to the property. It provides constructive notice of the foreclosure, so anyone who acquires an interest in the property takes it subject to the outcome of the foreclosure suit. 14 The mortgagor and junior lienholders have the right to cure the default and reinstate the loan while the lawsuit is pending, but once the court issues a decree of foreclosure, the right to reinstate the loan ends. 14 The decree of foreclosure establishes the amount that the mortgagor owes the mortgagee. It also states whether or not the mortgagee is entitled to a deficiency judgment if the foreclosure sale proceeds are less than the debt. (This depends on the anti-deficiency rules, discussed below.) 14 The sale after a judicial foreclosure is called a SHERIFF'S SALE or an execution sale (as opposed to a trustee's sale). The court appoints a receiver to conduct the sale. The receiver records a notice of levy. 14 The rest of the process depends on whether the lender is seeking a deficiency judgment. If not, the receiver must wait at least 120 days after recording the notice of levy before posting, publishing, and mailing out the notice of sale. The foreclosure sale purchaser receives a sheriff's deed immediately after the sale. (Like a trustee's deed, it carries no warranties.) 14 On the other hand, if the mortgagor will be liable for any deficiency, the receiver may issue the notice of sale immediately, but the property will be sold subject to the mortgagor's right of redemption. The foreclosure sale purchaser is given a CERTIFICATE OF SALE instead of a deed. 14 The mortgagor can redeem the property by paying the amount that the foreclosure sale purchaser paid for it (plus interest), and whatever the purchaser has spent on taxes,

insurance, and maintenance. If the purchaser was a junior lienholder, the mortgagor must also pay off that junior lien, plus interest. If the purchaser has used the property during the redemption period, the reasonable value of that use can be offset against the redemption price. 14 If it turns out that no deficiency judgment is necessary, then the redemption period only lasts for three months after the sale. If the mortgagor hasn't redeemed the property by then, the purchaser receives a sheriff s deed. 14 When the sale proceeds don't cover the debt, costs, and fees, and a deficiency judgment is entered against the mortgagor, the redemption period lasts one year. That's a long period of uncertainty for the purchaser. As a general rule, the borrower is entitled to remain in possession of the property during the redemption period, paying rent to the purchaser. 14 California law used to allow junior lienholders to redeem the property after a judicial foreclosure sale. However, now the defaulting mortgagor and the mortgagor's successors in interest are the only ones with the right of redemption within 12 months of the sale. 14 If they do redeem the property, a certificate of redemption is issued and recorded. If a deficiency judgment was entered and they haven't paid it, a judgment lien attaches to the redeemed property. Junior liens that were extinguished by the foreclosure sale aren't revived by the redemption. They're gone for good. 15 The same procedures are followed when a trust deed beneficiary chooses to foreclose judicially instead of using the power of sale. There are real disadvantages to the judicial foreclosure process in terms of both time and money. So why would a trust deed beneficiary choose judicial foreclosure? The most common reason is that it's the only way to obtain a deficiency judgment. Let's take a look at the rules that govern when deficiency judgments are available. 15 During the Great Depression in the 1930s, thousands of families lost their homes to foreclosure. Legislatures in many states, including California, passed laws to grant some relief to borrowers. For example, legislation was enacted that delayed foreclosure sales, extended redemption periods, and limited lenders' ability to obtain deficiency judgments. Most of these laws were temporary, emergency measures that later lapsed or were repealed, but restrictions on deficiency judgments are still in effect. 15 When a foreclosing lender is entitled to a deficiency judgment, the lender must apply to the court for the judgment within three months after the property is sold at the foreclosure sale. 15 The court will order an appraisal of the property's fair market value as of the time of the sale. The deficiency judgment will be the difference between the amount owed to the lender (including costs and fees) and either: 15 1. the fair market value at the time of the sale, or 15 2. the actual sale proceeds. 15 The deficiency judgment will always be the smaller of these two amounts. If the fair market value is less than or equal to the sale proceeds, the lender's total recovery, sale proceeds plus deficiency judgment, will equal the full amount owed. This won't be true if the fair market value is more than the sale proceeds. 15 Example: The borrower owes the foreclosing lender $100,000, including foreclosure costs and attorney's fees. At the foreclosure sale, the property was purchased for $75,000. The lender applies to the court for a deficiency judgment. 15 The court orders an appraisal. The appraiser estimates the property's fair market value at

the time of the sale was $85,000. Then the deficiency judgment would be for only $15,000, the difference between the appraised value and the debt. The lender's total recovery would be less than the $100,000 owed: $75,000, the sale proceeds, plus $15,000, the deficiency judgment, which equals $90,000. 15 This rule may seem hard on the lender, but it prevents an abuse that was once widespread. Foreclosing lenders used to purchase the property at the foreclosure sale for much less than it s fair market value, and then obtain a deficiency judgment for the difference between the sale proceeds and the debt. As a result, the lender came away from the foreclosure with far more than the borrower had owed. 15 Beyond this limitation on the amount of a deficiency judgment, there are rules that prohibit some deficiency judgments altogether. A lender cannot obtain a deficiency judgment: 15 1. after a nonjudicial foreclosure; or 15 2. after foreclosing on certain purchase money loans. 15 When a trust deed lender believes that a foreclosure sale is likely to result in a substantial deficiency, it may be worth the extra trouble to start a foreclosure lawsuit and get a deficiency judgment instead of exercising the power of sale. Even after a judicial foreclosure, a deficiency. judgment is often prohibited if the loan was a purchase money loan, that is, the loan funds were used to purchase the security property. 15 No deficiency judgment is allowed for a purchase money trust deed or mortgage carried back by the seller. 15 Suppose you sell me your land, and 1 give you a $40,000 trust deed as part of the purchase price. If I default and you foreclose, the sale proceeds are all you can get, no matter how severe the deficiency. There's an important exception, however. If the seller has subordinated the purchase money loan to a nonpurchase money loan, such as a construction loan, the anti-deficiency rule doesn't apply. The subordinated seller can obtain a deficiency judgment. 15 No deficiency judgment is allowed after a third-party lender forecloses on a purchase money loan if the security was residential property with one-to-four units, and one of the units was occupied by the borrower/purchaser. Most residential real estate loans fall into that category. This rule has been interpreted to include loans for the construction of a residence on vacant land. 15 Case Example: The Prunty's used their savings to buy an unimproved lot in Oakland, intending to build a home there. They borrowed $40,000 from Bank of America, giving the bank a trust deed on their lot. 15 Without improvements, the land was worth $7,500. After the house was built, the property value rose to $96,000. A landslide then destroyed the house, and the hazard insurance didn't cover landslides. 15 Foreclosure was inevitable, so the borrowers sued for a declaratory judgment. They contended that the $40,000 loan was a purchase money loan, and asked the court to rule that the bank could not obtain a deficiency judgment. The bank argued that it was a construction loan, not a purchase money loan. 15 The court agreed with the borrowers. Using the funds to build a home was essentially the same as using them to buy one. The bank wouldn't be allowed to apply for a deficiency judgment. Prunty v. Bank of America. 16 Let's change subjects and look at REVERSE MORTGAGES, also known as a reverse annuity mortgage, enables older homeowners, 62 years old or older, to convert their home

equity into tax-free income without having to sell their home, give up title, or take on a mortgage. 16 Prior to accepting an application for a reverse mortgage or charging any fees, the lender must refer the borrower to a reverse mortgage counseling agency approved by the Department of Housing and Urban Development. The lender must provide the borrower with a list of ten counseling agencies, including two that can do counseling by telephone. Then the lender must receive a certification from the applicant that the applicant has received counseling from an approved agency. The certification must be signed by the applicant and the agency counselor. To emphasize this, the applicant must receive a notice from the lender in conspicuous 16-point that is shown in your book. 16 Obviously, unlike a normal loan where presumably the lender's risk regarding the value of the collateral decreases with each payment, in a reverse mortgage the value of the property is 16 critical since the debt increases with each advance. Consequently, the legislation addresses some particular concerns when the borrower is absent from the property. The temporary absence from the home not exceeding 60 consecutive days cannot cause the mortgage to become due. Extended absences from the home exceeding 60 consecutive days, but less than one year, cannot cause the mortgage to become due if the borrower has taken prior action that secures and protects the home in a manner satisfactory to the lender, as specified in the loan documents. 16 The reverse mortgage is a lien on the home to the extent of all advances and interest. This lien has priority over any lien recorded after the reverse mortgage. Unless federal law provides otherwise, loan payments to the borrower are treated as proceeds of a loan and not as income for the purposes of determining eligibility and benefits under means-tested programs of aid to individuals. Additionally, undisbursed reverse mortgage funds are treated as equity in the home and not as proceeds from a loan, resources or assets for determining eligibility and benefits. 17 Changing our focus once more, let's look at a way real property is sold in a different way. There's another type of security agreement besides trust deeds and mortgages. We'll call them land contracts, although they go by various similar names: land sales contracts, installment land contracts, installment sales contracts, or real property sales contracts. 17 Land contracts were once a popular form of seller financing. They used to have some advantages over a trust deed, from the seller's point of view. However, court decisions have trimmed back the seller's rights, and added to the seller's obligations. As a result, land contracts are rarely used in California anymore. (One important exception: the CalVet program uses land contracts to finance purchases by veterans.) 17 In a LAND CONTRACT purchase, the buyer pays the seller in installments over a long period of time. Although the buyer usually takes possession of the property immediately, the seller retains title to the property as security for payment of the contract price. The seller doesn't deliver the deed to the buyer until the full price has been paid off, which is often many years later. 17 Under a valid land sales contract, the buyer holds an equitable title and is entitled to full use and enjoyment of the property. The seller keeps legal title until the last payment is made. 17 The parties to a land contract are called the VENDOR, the seller, and the VENDEE, the buyer. The vendor has legal title; the vendee has equitable title. The vendor's interest in the property decreases as the contract is paid off, and the vendee's interest increases.

Any payments I received by the vendor for insurance and taxes must be held in trust for this purpose. The vendee of residential housing can prepay all or any part of the balanced owed. However, the vendor may in writing prevent prepayment for up to 12 months after the purchase. 17 A land contract should be recorded to give constructive notice of the vendee's interest in the property. It's illegal for a vendor to transfer the property without assigning the contract to the new owner. If the vendor violates that rule, anyone who buys the property with actual or constructive notice of the contract takes title subject to the vendee's interest. When the vendee tenders full payment, the buyer will have to deliver title to the vendee, just as the vendor would have had to. 17 If the contract isn't recorded and someone buys the property without notice of the vendee's interest, the buyer can cut off the vendee's rights. The vendor will be liable to the vendee for breach of contract, but the vendee will lose the property. However, that can only happen if the vendee isn't in possession of the property, since possession gives constructive notice of an interest. 17 If a vendee defaults, the vendor can end the contract by sending the vendee a notice of election to terminate, and regain possession of the property. 17 The vendor may have to reimburse the vendee for the amount paid on the contract. However, the vendee's recovery may be reduced by any damages that the vendor incurred, or the vendee may be charged the rental value of the property during the period he or she was in possession. 18 A number of federal and state laws require real estate lenders to fully inform borrowers about the terms of their loans. Here's an overview of the main consumer protection laws affecting California lenders. 18 The TRUTH IN LENDING ACT (TILA) is a federal law that requires lenders to disclose the complete cost of credit to consumer loan applicants. The act also regulates advertising of consumer loans. Congress outlined these goals in the act, and delegated the responsibility for carrying them out to the Federal Reserve Board. The Federal Reserve Board's Regulation Z implements the Truth in Lending Act. REGULATION Z sets out the detailed rules that lenders must comply with. 18 A consumer loan is used for personal, family, or household purposes. 18 A consumer loan is covered by the Truth in Lending Act if it is to be repaid in more than four installments, or is subject to finance charges, and is either: 18 1. for $25,000 or less; or 18 2. secured by real property. 18 Thus, any loan secured by a trust deed is covered by the Truth in Lending Act, as long as the proceeds are used for personal, family, or household purposes (such as buying a home or college tuition). If the loan is used for business, commercial, or agricultural purposes, or made to other than a natural person, i.e., a partnership, however, the act doesn't apply. A loan for more than $25,000 isn't covered by the act if it isn't secured by real property. 18 The Truth in Lending Act's disclosure requirements apply not only to lenders but also to CREDIT ARRANGERS, go-betweens who help would-be borrowers find willing lenders. 18 The primary disclosures that a lender or credit arranger must make to a loan applicant are the total finance charge and the annual percentage rate. The TOTAL FINANCE CHARGE is the sum of all fees the lender charges a borrower in exchange for granting the loan. This includes the interest on the loan, plus charges like the origination fee, points, finder's fees, and service fees. Title insurance costs, credit report charges, the appraisal fee, and

points paid by the seller are not included. 18 The ANNUAL PERCENTAGE RATE, APR states the relationship of the total finance charge to the amount of the loan expressed as an annual percentage. The APR is a percentage rate reflected as an annual rate and includes all interest, points, and fees. A loan's APR is higher than its annual interest rate, since it reflects all the other finance charges in addition to the interest. A loan with an 11% annual interest rate might have an 11.25% APR. 18 The lender or credit arranger must give the loan applicant a clear, easily understandable disclosure statement within three days of application and before any fees or charges are collected, other than reasonable credit report fees. In addition to the total finance charge and the APR, the statement must disclose the total amount financed, the payment schedule, the total number of payments, the total amount of payments, and information regarding any balloon payments, due-on- sale clauses, late fees, or prepayment charges. A real estate loan must also state whether the loan may be assumed by someone who buys the security property from the borrower. 18 Additional disclosures are required for adjustable-rate loans. The lender must give the applicant an informational brochure on ARM loans, the Consumer Handbook on Adjustable Rate Mortgages, published jointly by the Federal Reserve and the Federal Housing Finance Board. The lender must also provide specific information regarding the particular ARM loan program being applied for, such as the index, the initial rate, and any rate or payment caps. 18 The Truth in Lending Act has some special rules for only home equity loans. A HOME EQUITY LOAN is a loan secured by the borrower's existing residence, as opposed to a loan financing the purchase or construction of a residence. When the security property is the borrower's principal residence, the act gives a home equity borrower a right of rescission up until midnight on the third business day (Sunday and federal holidays excluded) after signing the agreement, receiving the disclosure statement, or receiving notice of the right of rescission, whichever comes latest. If the borrower never receives the statement or notice, the right of rescission does not expire for three years. The Truth in Lending Act also requires certain disclosures for home equity plans that involve repeated extensions of credit, versus a single loan. 18 The Truth in Lending Act strictly controls advertising of credit terms. Its advertising rules apply to anyone who advertises consumer credit. 18 For example, a real estate broker advertising financing terms for a listed home has to comply with Regulation Z. 18 The cash price for a property and a loan's annual percentage rate can always be advertised. If any other particular loan terms, the down payment or the interest rate, for 18 example, are stated in an ad, then all the terms must also be included. For example, if an ad says, "Assume 11% VA loan," it will violate the Truth in Lending Act unless it goes on to reveal the APR and all the terms of repayment. However, general statements such as "low down" or "easy terms" don't trigger the full disclosure requirement. 19 When a seller carries back a purchase money loan on residential property, California law requires that certain disclosures be made to both buyer and seller if an "arranger of credit" is involved. For the purposes of the statute, an arranger of credit is anyone (other than the buyer or the seller) who: 19 1. is involved in negotiating the terms of the loan agreement; 19 2. participates in preparing the financing documents, or

19 3. is directly or indirectly compensated for arranging the financing or the sale. 19 There's an exception for escrow agents and for lawyers representing either party, these aren't considered arrangers of credit. If the buyer or seller is a lawyer or real estate agent, he or she is considered an arranger of credit if neither party is represented by a real estate agent. 19 It applies if a seller gives the buyer credit for some of the purchase price, if: 19 1. the property is residential with one-to-four units, 19 2. the credit arrangements involve a finance charge or provide for four or more payments of principal and interest or interest only (not including the down payment), and 19 3. an arranger of credit is involved. 19 However, a transaction is exempt if it's already covered by other disclosure laws, such as the Truth in Lending Act, the Real Estate Settlement Procedures Act, or the Mortgage Loan Broker Law. 19 When the seller financing disclosure law applies to a transaction, the required disclosures must be made before the buyer signs the note or security agreement. The seller must make disclosures to the buyer, and the buyer must make disclosures to the seller. The arranger of credit is responsible for ensuring that each party discloses all required information to the other and each party sign and receive a copy of the disclosure statement. 19 The statute contains a long list of required disclosures, including but not limited to: 19 1. The terms of the note and security agreements. 19 2. The terms and conditions of senior encumbrances (such as a first trust deed that the buyer will be assuming or taking subject to). 19 3. Whether the financing may result in negative amortization. 19 4. Whether the financing will result in a balloon payment (if so, the buyer must be warned it may be difficult to obtain refinancing to cover the payment). 19 5. Employment, income, and credit information about the buyer, or a statement that the arranger of credit has made no representation regarding the buyer's creditworthiness. 19 6. A statement suggesting filing of a "request for notice of delinquency" and a "request for notice of default." 19 7. A warning of possible limitations on seller's ability, with a foreclosure, to recover proceeds of the sale financed. 20 Real estate agents often help buyers obtain financing. This assistance may go beyond simply helping the buyer apply to one institutional lender. In some cases, it's necessary to get loans from two or more lenders to raise enough cash to close the transaction. 20 California's MORTGAGE LOAN BROKER LAW (also known as the Necessitous Borrowers Act or the Real Property Loan Law) regulates real estate agents who act as loan brokers. The law requires a loan broker to give the borrower a disclosure statement, and for loans secured by residential property, the law places restrictions on the fees and commissions paid by the borrower or received by the loan broker, and regulates other aspects of the loan terms. We'll give only an overview of some of the law's key provisions here. 20 The disclosure statement required by the Mortgage Loan Broker Law must be on a form approved by the California Real Estate Commissioner. It discloses all the costs, including fees received by the broker involved in obtaining the loan, and the actual amount the borrower will receive after all costs and fees are deducted. The borrower must receive the statement within three business days of receipt of the loan application or before the borrower becomes obligated to complete the loan, whichever is earlier.

20 A disclosure statement is required whenever a real estate agent negotiates a loan or performs services for borrowers or lenders in connection with a loan. 20 It's required for loans secured by commercial property as well as for residential loans. However, there's an important exception. The disclosure statement is not required if: 20 1. the lender is an institutional lender, and 20 2. the commission paid by the borrower is 2% of the loan amount or less. 20 The Mortgage Loan Broker Law limits the commissions and costs that a real estate agent may charge the borrower for arranging a loan secured by residential property with oneto-four units. These restrictions only apply when the security agreement is as stated in the chart at the top of the next page. 20 For these loans, the costs of making the loan (such as appraisal and escrow fees) cannot exceed 5% of the loan amount, or $390, whichever is greater. However, the costs charged to the borrower must never exceed $700, or exceed the actual costs. 20 The Maximum Commissions That An Agent Can Charge Are: 20 First Trust Deeds for less than $30,000: 20 5% of the principal if the loan term is less than three years, and 20 10% of the principal if the term is three years or more. 20 Junior Trust Deeds for less than $20,000: 20 5% of the principal if the term is less than two years, 20 10% of the principal if the term is at least two years, but less than three years, and 20 15% of the principal if the term is three years or more. 20 The Mortgage Loan Broker Law prohibits balloon payments in certain residential loans secured by first trust deeds for less than $30,000 or junior trust deeds for less than $20,000. Balloon payments are prohibited in these loans if the loan is to be paid off in less than three years. If the security property is an owner-occupied home, balloon payments are prohibited when the loan term is less than six years. These rules don't apply to seller financing, however. For the purposes of this law, a balloon payment is one that is more than twice as large as the smallest payment required by the loan agreement. 20 When a loan is negotiated in Spanish, Chinese, Tagalog, Vietnamese, or Korean and not English, the broker must give the borrower a written translation of the loan documents in that negotiated language before the borrower signs them. This rule only applies to loans used for personal, family, or household purposes (such as the purchase of a home). 20 The borrower can prepay up to 20% of the unpaid balance at the time of payment in any 12-month period during the first seven years of the loan without a prepayment penalty. If more than the 20% is paid, the excess is subject to a maximum of six months' interest. After seven years there is no prepayment charge. 20 The late charge provisions are the same as for residential property, except the rate is 10% of the installment or $500, whichever is greater. 21 The California Legislature found that homeowners whose residences are in foreclosure have been subjected to fraud and unfair dealings by home equity purchasers. During a foreclosure period, the poor, elderly, and financially unsophisticated are vulnerable to the harassment of equity purchasers who induce homeowners to sell their homes for a small fraction of their fair market value through the use of schemes, which often involve misrepresentations, deceit, intimidation and other unfair dealing practices. Consequently, the legislature adopted some rules for home equity purchasers of owner-occupied property with one-to-four units after the recording of a notice of default. 21 The contents of the equity purchase contract and the cancellation notice are set by the

legislature. The seller may not waive any rights under this law and can cancel the contract until midnight of the fifth business day after the equity sales contract was signed, or until 8:00a.m on the foreclosure sale date, whichever occurs first. Taking unconscionable advantage of the equity seller is unlawful and the seller has two years from recording the equity sale to rescind the contract. However, there can be no rescission in the event of a subsequent bona fide purchaser or encumbrancer. The equity seller has four years to bring a civil action against the equity buyer and may recover damages or equitable relief, attorney's fees and possible exemplary damages (not less than three times the equity seller's actual damages) or a civil penalty of up to $2,500. If the equity purchaser fails to comply with the statutory law, the purchaser may be fined not more than $10,000, sentenced to jail for not more than one year, or both. An equity purchaser is one who acquires title to a residence in foreclosure, except one who acquired title: 21 1. for use as a residence; 21 2. by a deed in lieu of foreclosure; 21 3. by trustee's deed; 21 4. by a statutory sale; 21 5. pursuant to a court order, or 21 6. from a spouse, blood relative, or blood relative of a spouse. 21 The homeowner in distress is typically approached by a "representative" of an "interested financial party" offering to help the homeowner in foreclosure. The homeowner needs to know that the representative must provide the following: (1) a valid current California Real Estate Sales License, (2) written proof that the representative is bonded by an admitted surety insurer in an amount equal to twice the fair market value of the property, and (3) a statement in writing, signed under penalty of perjury, that the representative is both (1) and (2) above. 22 The California Legislature placed numerous restrictions on foreclosure consultants who were found to use fraud and harassment to obtain a fee from the property owner, representing that the consultant could provide beneficial services to save the home from foreclosure. These consultants often charged high fees, secured their fee by a deed of trust on the residence to be saved, or performed worthless services in order to collect a fee. A foreclosure consultant is any person who, for compensation, will: 22 1. stop or postpone the foreclosure; 22 2. obtain any forbearance from the beneficiary or mortgagee; 22 3. assist with reinstatement of the loan; 22 4. obtain an extension of time to reinstate the loan; 22 5. obtain a waiver of the acceleration clause in the note; 22 6. assist the owner with obtaining any loan or other funds; 22 7. protect the owner's credit, or 22 8. save the residence from foreclosure. 22 There are a number of persons who are not considered foreclosure consultants: for example, attorneys providing legal services, licensed accountants, the person holding the lien being foreclosed, and institutional lenders. The law covers owner-occupied residences of one-to-four units and starts after the recording of the notice of default. The contents of the foreclosure consultant contract are established by the law. No waiver of rights or limitations of liability are allowed in the contract. The property owner can cancel the contract within three business days following its signing. Foreclosure consultants may not: 22 1. receive any compensation until full performance of all terms of the contract;

22 2. receive a fee of more than 10 percent per year of the loan amount; 22 3. take any security interest for the consulting fee; 22 4. receive a fee from a third party without a full disclosure to the property owner; 22 5. acquire any interest in the property being foreclosed; 22 6. receive a power of attorney from the property owner except to inspect the documents, or 22 7. induce the property owner to enter into a contract that does not comply with the law. 22 The property owner has four years from a violation of the law to sue for recovery of actual damages, attorney's fees and court costs, plus, it is possible to recover exemplary damages. Any violation of law subjects the financial consultant or representative to a fine of not more than $10,000, a jail term not exceeding one year, or both for each violation. The financial consultant is liable for all actions of any representative. The representative must provide the owner with written proof of a valid sales license and bonding, for twice the fair market value of the residence. This must be done prior to any interest being transferred by the owner. 23 The SAFE ACT requires all states and 5 territories to implement a licensing system for residential mortgage loan originators. California passed legislation allowing the Department of Real Estate (DRE) to implement the requirements of the SAFE Act. 23 Within 30 days of commencing loan activity, all licensees must report to the DRE if they make, arrange or service loans secured by real property. This requirement applies to both residential and commercial businesses. In the future when all the requirements are met, the DRE will issue a mortgage loan originator (MLO) license endorsement. Current information is available at dre.ca.gov. 23 This DRE endorsement will carry a nationwide identification number known as a "unique identifier" which will be assigned by the NMLS&R, the national governing organization, when an MLO applicant registers on the system. 24 Suppose a borrower wants to give the lender a security interest in standing timber to be cut, as extracted minerals, or crops growing in a field (agricultural lien) with the idea that the lender or more removed the collateral if there is a default. How is this accomplished? The secured party with a security interest in standing timber or as extracted minerals will record (in the county where the real property is located) a financing statement (Form UCC-1) that describes the collateral and includes a description of the real property on which the collateral is located. Once recorded, it becomes constructive notice of the security interest to subsequent purchasers or lenders. The secured party with a security interest in growing crops will use the same financing statement, but has a choice of recording it in the county where the collateral is located or filing it with the Secretary of State's office in Sacramento or both (probably the best choice). 25 Credit scores are assigned numbers used by lenders to determine whether a consumer will get a loan and at what interest rate. Individual lenders often contract with a credit reporting agency, such as Trans Union, Experian, or Equifax, who compile consumer credit information. These companies then contract with a credit scoring company, more often than not, Fair, Issacs, and Company, who own the mathematical model used to create the score. They provide the lender with a list of "reason codes" that the lender can choose from when receiving scores for consumers applying for mortgages. The "reason codes" can include things like, "too few bank card accounts," "too many subprime accounts," etc. The credit scoring company uses information from a consumer's credit report, together with these "reason codes" and the mathematical formula to create an individual's credit

score. 25 The law now: 25 1. requires lenders to provide consumers with their specific credit score, what credit information went into making up the score, and an explanation of how credit scores work in the loan approval process, 25 2. compels credit reporting agencies to correct inaccurate information in a timely manner, and 25 3. provides consumers with additional legal recourse if an agency continues to report inaccurate information once they become aware that a mistake has been made. 26 Let s summarize what we covered in this chapter: 26 1. A promissory note is the maker's promise to repay a debt. The payee may transfer the note to another person. Almost all promissory notes are negotiable. 26 2. A promissory note can be a straight note (with interest-only payments) or an installment note (with payments of principal and interest). An installment note may be fully amortized, or partially amortized with a balloon payment required at the end of the loan term. 26 3. A security agreement makes real property collateral for a loan, creating a lien and giving the lender the right to foreclose if the debt isn't paid. A deed of trust includes a power of sale clause, which enables the lender to foreclose nonjudidally. Mortgages historically did not have power of sale clauses, and therefore had to be foreclosed judicially. Nonjudicial foreclosure is faster and cheaper than a foreclosure lawsuit. 26 4. Most loan agreements permit the borrower to prepay, but nonresidential loans can be locked in. A residential borrower must be allowed to prepay. If residential property is owner occupied, only a limited prepayment penalty may be charged, and only during the first five years of the loan term. 26 5. A lender may impose late fees and charge a default interest rate on delinquent amounts. An acceleration clause gives the lender the right to declare the entire loan balance due if the borrower defaults. The loan agreement may provide that the lender can impose a prepayment penalty after accelerating the loan. 26 6. A due-on-sale clause gives the lender the right to accelerate the loan if the borrower transfers the security property to a new owner. The lender may be willing to let the new owner assume the loan at a higher rate of interest, or upon payment of an assumption fee. 26 7. When a trust deed contains a subordination clause, the lender agrees to subordinate its lien to another trust deed that would otherwise have lower lien priority. The clause should establish strict standards for the subordinating trust deed to minimize the subordinated lender's risk. 26 8. To foreclose nonjudidally, the trustee records a notice of default and mails copies to the borrower, all junior lienholders, and other interested parties. At least three months after recording the notice of default and at least 20 days before the sale, the trustee must record, post, publish, and mail out a notice of sale. 26 9. A trustee's sale can be prevented by curing the default and reinstating the loan, by paying off the entire loan (plus costs) to redeem the property, or by giving the lender a deed in lieu of foreclosure. 26 10. Trustee's sale proceeds are first applied to the foreclosure costs, then to the foreclosed trust 26 deed, then to junior liens in order of priority. Anything left over belongs to the borrower.

All 26 junior liens are extinguished by the sale. The purchaser is given a trustee's deed. 26 11. For judicial foreclosure, the lender files a lawsuit against the borrower and junior lienholders. The court issues a decree of foreclosure, and the property is sold at a sheriffs sale. If the lender obtains a deficiency judgment, the sale purchaser is only given a certificate of sale, and the borrower has one year to redeem the property. If the borrower doesn't redeem it, the purchaser is finally given a sheriffs deed. 26 12. If the foreclosure sale proceeds don't cover the debt and the lender's costs, in a few cases the lender is entitled to a deficiency judgment. A deficiency judgment is never available after a nonjudicial foreclosure, or if the loan was a residential purchase money loan. A deficiency judgment also isn't available after foreclosure of a seller-financed purchase money loan (on any type of property), unless it was subordinated to a nonpurchase money loan. 26 13. In a land contract purchase, the vendee (buyer) takes possession of the property immediately, but the vendor (seller) retains legal title as security for payment. The vendee has equitable title. The vendor doesn't deliver the deed to the vendee until the contract price has been paid off. 26 14. The federal Truth in Lending Act (TILA) and California's seller financing disclosure law and Mortgage Loan Broker Law require lenders and credit arrangers to fully inform residential loan applicants about the cost of financing. The Truth in Lending Act also regulates consumer finance advertising. 26 15. Because of problems with equity purchasers of foreclosure property and those selling foreclosure consulting services, both practices are regulated in California. 26 16. The SAFE Act requires all states and five territories to implement a licensing system for residential mortgage loan originators. Within 30 days of commencing loan activity, all licensees must report to the DRB if they make, arrange, or service loans secured by real property. When all requirements are met, the DRE will issue a mortgage loan originator (MLO) license endorsement. 26 17. Recording a financing statement gives constructive notice of a security interest in timber to be cut or as extracted minerals. Recording or filing with the secretary of state works for agricultural liens. 27 Hopefully the content in this chapter has provided an understanding of the legal aspects of the world of real estate financing..